Reed Hastings had a good idea. Why bother going to the local DVD rental outlet when he could just mail you the DVD? Sure, there were delays using the mail but you could more than offset that by offering a library far larger than even the biggest retail outlet could hope to match. If you brought the studios in as partners, they could supply you with all the DVD's you'd need to meet demand. Since your cost of goods is zero, you can afford to have inventory spread throughout all your customer's houses and not fuss about how long they kept the DVD. You could even offer different price plans for different customers - those who checked out a couple of movies at a time would pay a lower price than those who kept 5 or 6 DVD's before returning one. Hastings took that idea in 1997 and formed Netflix.
In essence, Hastings is running a fulfillment service. Each day, he pays someone to open incoming mail, scan and store the enclosed DVD, and someone else to pick and pack newly selected DVD's. He also pays the postman to carry the DVD's back and forth to his customers. At the core, that's his business. The number of DVD handlers he hires rises and falls in direct proportion to his business volume.
In addition to the DVD handler costs, he has overhead costs. That includes rent, interest, equipment, utilities and people to maintain his website, negotiate contracts, sweep the floor, answer the phone, write blurbs about the various DVDs, cut paychecks, pay bills and so on. Those costs are somewhat fixed in that the expenses are needed regardless if Netflix has one or one million customers. In any business, you try to minimize both costs but the key to a high volume business is to make sure you make at least some money on each additional transaction.
It's that last bit that's hurting Netflix and it's hurting them big time. The average customer signs up for the three-DVD out plan which means the customer can keep up to three DVDs indefinitely in exchange for a $19.95 monthly fee. Netflix's problem is that the average customer rents 7 movies a month making the average gross a little under $3 per rental. When the customer returns one or all their DVDs, they get new DVDs. And there's the rub. The happier the customers are with the service, the more it costs Netflix to service them. Since Netflix's income is fixed at an average $20 per month the last thing they want happening is customers using their service because that drives their operating cost up. It's a peculiar business model in that the happier your customers are the more money you lose.
So Netflix compensates for that quirk in their business plan. If you're a heavy Netflix user, Netflix treats you to their passive-aggressive service model. Instead of turning the DVDs around as soon as one arrives, they'll delay shipping your next DVD. Remember that huge library of DVDs that gave them a competitive advantage over the local outlet? It doesn't do the cinephile much good if Netflix won't ship to them.
It's funny how a new idea can become old hat so quickly. When Hastings started Netflix, it was pretty much the only game in town. Hastings leveraged his capital by partnering with the studios. But the studios aren't locked into Netflix and anyone with sufficient capital can enter the same market. Google "dvd rent" and a host of offerings pop up. The most serious competitor is Walmart. Walmart is a company that makes its money by ruthless cost cutting. Sam Walton, Walmart's founder, understood that price is a key determinate in making a sale. Bill Gates learned the lesson very well when he offered DOS for $60 against Digital Research's $200 product. Since customers have a difficult time seeing value other than price, price tends to win out in the long run. Walmart's initial foray into the DVD rent by mail market is to undercut Netflix's price by 25%.
Instead of looking at how to lower their operating costs, Netflix's response was to raise their price. Ford made a similar blunder in the early 80's when Japanese imports were cleaning up. Back then, Ford's offerings lived up to the Fix Or Repair Daily moniker, gobbled gas when real gas prices were higher than they are now and generally missed the market. Ford's initial response to their declining market share was to raise prices. It didn't work and Ford ended up ceding more market share to Japan before redesigning their product lines.
The Washington Post reports that
On Thursday, Netflix, based in Los Gatos, Calif., reported a loss of $5.8 million for the first quarter, more than twice the $2.4 million loss the company reported in the first quarter of 2003. To reverse that trend, the company said it would raise its monthly subscription rate in June from $19.95 to $21.99 per month -- a move it conceded might make some customers unhappy.As the Post notes, Netflix anticipates that more customers will bail in response to the price increase. If you're a Netflix customer, you can profit from their anticipating your leaving. As of 10:23 PM on April 17th, Netflix customers who cancel their accounts are offered a much better deal than what they had before. In my case, my monthly rental fee was $14. When I clicked the cancel button, they acted like a Tijuana street merchant and said "Wait! Don't Leave! We'll make it $11.95!" If you're a regular 3 DVD-out customer they may not lower the price but something tells me they're clueless as to how the market would react to their price hike and hedged. The pricing meeting would have gone something like this:
"Let's raise our prices!"
"What? Walmart is underselling us!"
"Hmmm. Good point. How about this? Let's raise our prices and if a customer objects, we lower that customer's price. That way the ones who aren't paying attention will pay us more and the price-sensitive customers who would defect to Walmart will stay with us because they're now getting a better price than Walmart's offering! Not only that, Walmart will never know we undersold them because all they'll see is our posted price increase. Net result is our bottom line goes up!"
"Brilliant! Let's do it!"
One drawback with that strategy is it pisses some customers off. Those pissed off customers tell other customers and pretty soon Netflix sees a rash of cancellations followed by re-subscribes at the lower price. So get your red-hot discount before Netflix reconsiders their Tijuana pricing scheme.
Another drawback to the strategy involves posted prices. A first-time customer will look around and see Walmart's lowest price of $15.58 vs. Netflix's posted low price of $21.98 and go with Walmart. Since the first time customer is unaware of Netflix's willingness to discount, they'll go with Walmart's lower price. The nuance of having 22 distribution centers won't drive many first time users just as Digital Research's more subtle features didn't fend off Microsoft's DOS.
A second way to profit involves risk. Netflix's stock is currently offered at $30/share. Etrade reports that that works out to a price/earning ratio of 418. What it says is that you have to pay $418 to buy a company that earns $1. Price/Earning ratios (PE) measure the markets expectation of the growth prospects of a company. For an established, profitable company in a mature market, PE's can range from $5 to $30. At $418, Netflix is ridiculously overvalued. What the market is saying by valuing the PE 15 times higher than a normal high end PE, is it expects Netflix to become 15 times larger than it currently is. Netflix's raising prices against a price cutter like Walmart doesn't make that expected 15x growth too likely. Factor in new delivery models such as Movielink's video on demand and Netflix's current business model loses even more of its luster. If I'm right that the market is grossly over valuing Netflix, the market will eventually react by dropping the PE to a more reasonable 10-30 range. That means the share price will drop by a factor of 13 to 40 or somewhere between $0.66 and $3 vs. its current $30. If it drops below $1 it'll be delisted from the NASDAQ. To avoid that, Netflix will have to buy back shares to beef up its stockholder value. This means that Netflix is probably a good short sell opportunity right now.
Walmart's entry into the market underscores Netflix's key vulnerability - they're losing money if their customers like them too much. That's a terrible place for a business because the only way to deal with it is to piss off your customers so they don't like you so much. The key to success is to make money on each transaction while keeping your customers happy and right now Netflix is losing money on each transaction and pissing off their customers. A more reasonable pricing scheme instead of "all you can watch but not too much otherwise we'll ration you and piss you off" is to charge a fee for a set number that covers your overhead and then incrementally charge for each additional use. Tie that to investing in machinery that minimizes the labor to handle the DVDs. Pepsi and Coke can make money packaging, delivering and marketing sugar water only by automating most of their manufacturing process. Netflix will need to follow suit if they're to survive Walmart.
Secondly, Netflix is going to have to figure out how to deliver movies on demand to fend off becoming obsolete altogether. Netflix exists on its current business because very few homes have fat data pipes. That's going to change. In my neighborhood, I can either buy 1.5 mbits/second via DSL, or for a few more dollars, 2 mbits/second via cable. At 1.5 mbits/second, I can download a movie in under an hour. That's a task that's easily handled overnight. Not everyone will have 1.5 mbits/second but a lot of Netflix's customer base will. The folks that don't have fat pipes are going to be even more price sensitive than Netflix's current customer base. Those facts, defecting high-end customers and lower priced competition, makes the 418 PE all the more unlikely.